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Today's WrapUp by Jim Puplava 05.12.2003 Mon Tue Wed Thu Fri Archive |
Anomalies and the Moral Hazard
When I got in this business in the late 70’s the financial markets acted as a check on government actions to inflate the money supply or expand credit. We used to watch the money supply figures each week for signs of Fed induced inflation of the monetary aggregates. If the money supply figures rose, interest rates would rise, bonds would tank, stocks would fall, and the dollar would fall. Large trade or budget deficits would send the dollar crashing. Today it is just the opposite. The bond market no longer acts as a restraint on government efforts to reflate. In fact, bond managers such as Pimco believe the Fed should inflate and use monetary stimulus along with fiscal stimulus in order to avoid deflation. Bond managers no longer perceive inflation as a risk; they are more concerned about asset deflation. With so much debt in this country bond managers are more worried about credit spreads and defaults than they are inflation. So any effort by the Fed to intervene in the bond markets by monetizing debt or large government deficits are looked upon favorably.
Burn the Currency
It has become apparent that traditional Fed policy of lowering interest rates has failed to give us a sustained recovery in the economy. It has in effect given us additional bubbles to worry about in mortgages, housing and consumption. However, it is always reminding the financial markets that it has plenty of other tools at its disposal to fight deflation besides monetary easing. They can monetize Treasury debt by purchasing Treasury bonds in an effort to drive down long-term rates, a policy which they are now actively pursuing. By driving and keeping long-term rates low they can generate another round of mortgage refi’s and keep consumption going for most consumers who are now relying more heavily on debt to live. Another option is the purchase of non-dollar denominated currencies in order to drive down the dollar. They can also intervene in the financial markets to prop up stocks when necessary, although they will never admit it other than to say it is a policy option. In Japan, the government is intervening in the stock market in an effort to prop up the market and buying shares of virtually bankrupt institutions.
It is obvious at this point that the “strong dollar policy” has been abandoned. Now there is a deliberate effort to drive down the dollar to restore pricing power for U.S. companies and bring down the trade deficit, which is running around 5% of GDP. The only problem with depreciating your currency is how to make the rest of the market go along with devaluation. The Fed has done a good job of this by scaring the hell out of the financial markets with memories of deflation from the Depression era. Today the dollar plunged at the open, thanks to the U.S. Treasury Secretary talking the dollar down. The stock market response to a dollar fall was to rally. Initially the stock market fell, bonds plunged, and the gold markets went up. Gold pulled back, stocks rose, and the dollar-recouped part of its losses.
The financial markets responded with giddy enthusiasm with each bit of bad news. A lower or depreciating dollar as shown in the graph below is now considered good news. A lower dollar is expected to make U.S. products more competitive, restore purchasing power for U.S. manufacturers, help increase corporate profits through currency gains and lower the trade deficit. A depreciating dollar means that the U.S. will be paying more money for just about everything it imports. The financial markets are being forced to accept the lesser of two evils of more inflation or a deflationary depression. The markets are opting for more inflation.
However, I must point out the kind of deflation the Fed is referring to is asset deflation. Goods inflation already exists. Just check your grocery bill, your heating bill, the cost of filling your tank, dry cleaning, housing, sporting events, movie tickets, insurance costs, restaurant meals and last but not least, your taxes. Inflation is also rising in the service industry where the costs of just about every service I utilize is going up. My dentist, doctor, attorneys, accountants, and lawn care service have all raised their fees high single digits, some double digits over the last year. Some services we use are now passing costs on a regular basis. Here in California there is a joke going around that expresses the inflation theory well. In California, the definition of a millionaire is a homeowner. Therefore, when you hear Fed or government officials talk about deflation they are referring to asset deflation, meaning the collapse of the stock and bond market, or real estate prices. There is simply too much debt in the financial system and economy so the Fed can’t afford to allow asset deflation or the whole house of cards comes tumbling down.
Keeping interest rates low and depreciating the dollar has helped to keep the Dow’s fall to a minimum as shown in the two graphs below, depicting the Dow, interest rates, and the dollar.
The Green Light to Speculate
In the financial markets, participants have been given the green light to go ahead and speculate because Greenspan has placed a put underneath the stock and bond markets. They will try to prop up the markets by whatever means necessary to keep it within a narrow trading range in the hopes that enough stimulus and pricing power can be applied to resurrect corporate profits, and along with it the stock markets. The same approach used in driving down interest rates and reliquefying consumer balance sheets will be applied to the financial markets. I would not be surprised if the Fed floods the market with enough cheap money and monetizes debt to create another round of mortgage refi’s to keep consumption strong. Instead of five percent mortgages you may soon see four percent mortgages if the economy weakens further. If you think the costs of things you need to live have gone up you haven’t seen anything yet. Another way of looking at dollar depreciation is to view it in terms of what it will purchase overseas. The graph of what the dollar buys in foreign currencies can be seen below. (See Mike Hodges' Editorial)
One problem all of this intervention is creating is the various anomalies that are now operating in the financial markets. You having rising bond prices that are now accompanying a falling dollar; you have lower interest rates with record trade, current account, and budget deficits; you have rising bond prices going along with rising commodity prices; and lastly, you now have rising stock prices that accompany poor and anemic earnings. Unbelievably analysts are now forecasting profit growth of more than 10-15 percent per annum for the next five years. These profit forecasts stand in sharp contrast to the ability of companies to raise sales, not to mention real earnings difficulties. You can’t grow your business 10-15 percent per year by laying off workers every year to achieve profit targets. From a macro perspective, this strategy is contractionary.
Capping The Gold Markets
The only problem the Fed is going to have in devaluing the dollar is the gold market. Gold is a barometer of financial difficulties and confidence in the financial system. As the Fed inflates, it must also cap gold prices. A rising gold market signals trouble for the financial markets, especially for the bond markets. Therefore the central banks, and especially the Fed, must keep gold prices from rising too rapidly. Just as they are trying to manage the financial markets, they must also manage gold. Rising gold prices and rising goods prices spells trouble. Even John Q. might put two and two together when he looks at what he spends each month to live and a rising gold price. It is not surprising to many in the gold markets to see the price of gold fall on days gold should do well. A depreciating dollar is good news for gold and silver and bad news for financial assets. At the moment that is one of the big anomalies of the financial markets. They aren’t acting and responding in the usual way. The alchemists are tinkering with the financial formulas in the hopes of creating economic and financial prosperity. In the end history teaches us that they will fail. In his new book “Adventure Capitalist,” investor and author Jim Rogers warns, “All knowledgeable economists in history have warned against debasing the currency—which Lenin advised was the most effective way to overturn the existing basis of any society, because it is so subtle and insidious…John Maynard Keynes and Ernest Hemingway have agreed. Keynes said, ‘Lenin was certainty right.’ Hemingway, who saw much of the world close to the ground, observed, ‘The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring temporary prosperity; both bring a permanent ruin. Both are the refuge of political and economic opportunists.’”
After falling early this morning, the Dow gained 122 points to close at its highest point in four months. Aggressive speculation in the Nasdaq also propelled the tech-laden index to an 11 month high. Stocks rose on speculation that earnings will accelerate this year as one Wall Street firm after another raise their earnings estimates. Pro forma profits or C.R.A.P. earnings are expected to grow by 6 percent in Q2, 12.5 percent in Q3, and 21 percent by Q4.
Cisco led today’s rally in the Nasdaq as fund managers piled into the stock based on an improvement in earnings in 2004. The fund manages believe Cisco is cheap based on next year’s pro forma estimates. Cisco trades at 29 trailing earnings, 28 times this year’s earnings, and around 26 times next year’s profits. If you extend earnings out far enough this stock eventually looks cheap. Analysts are getting way ahead of themselves if they think that currency gains will deliver robust profits. Against gains from currency depreciation of the dollar, companies will also have to deal with pension contributions and rising raw material and labor costs. Already many food processors have been shocked by the rise in ingredient costs. This has forced food processors to raise prices on everything from chocolate bars to cereal. Currently there is no moderation in the inflation trend in ingredient costs, which is hurting profit margins. Companies are now warning that profit trends in the upcoming quarters could be hurt. Some companies such as Fleming have recently gone bankrupt. Not all dollar depreciation is good. The dollar’s fall also raises prices for companies, something Wall Street seems to gloss over when they put on their rose-colored earnings glasses.
Market volume was anemic at 1.36 billion on the NYSE. Nasdaq volume was a little brisker with 1.77 billion shares exchanging hands. Market breadth was positive by 23-10 on the Big Board and by 20-12 on the Nasdaq. The VIX fell by .62 to 21.42 and the VXN rose slightly by .49 to 32.48.
Bloomberg's Overseas Market Summary
Shares of European exporters fell on concern the dollar's drop to the lowest in more than four years will erode the value of companies' U.S. sales. U.K. retailers advanced after Selfridges Plc and Debenhams Plc received takeover offers. The Dow Jones Stoxx 600 Index was little changed, down 0.12 to 193.52, with auto-related stocks leading percentage declines. The Stoxx 50 was near unchanged at 2295.74, rebounding from a drop of as much as 1.4 percent. Benchmark indexes fell in seven of the 17 Western European markets.
Asian stocks rallied, led by semiconductor-related shares such as Tokyo Electron Ltd. and Samsung Electronics Co., after Intel Corp. and Nvidia Corp. said demand for computer chips is improving. Japan's Nikkei 225 Stock Average gained 0.9 percent to 8221.12, a five-week high. The Topix index added 0.7 percent to 829.26, with computer-related shares contributing 31 percent of its advance.
Copyright © 2003 Jim Puplava
May 12, 2003
Charts courtesy www.stockcharts.com and Grandfather Economic Report
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